McClatchy: A Unique Asset At A Low Valuation, And Not As Risky As It Seems – Seeking Alpha

At first glance, McClatchy (NYSE:MNI) is a tough one to stomach. It is a newspaper publisher that sits on $873 million in debt, and has an under-funding of its pension calculated at roughly $600 million and a $70 million market cap (with $5 million in cash on the balance sheet as of the most recent filing). There’s no mystery behind the valuation: secular trends haven’t been positive for newspaper circulations. Weekday print distributions have fallen from 2.14 million in 2010 to 1.476 million in 2016 for McClatchy, and revenues have declined from $1.3 billion to $977 million over the corresponding years. All of this put together would typically leave us saying, “Are you nuts?!” to anyone looking at going long.

However, financially, I’ve seen worse. There are some interesting dynamics in the numbers that say to me there is no way the equity deserves such a discounted valuation. I may have left out the fact that the company generated $62.4 million in free cash flow to the firm (FCFF = CFO – CapEx) last year, which is an enormous free cash flow yield that has the valuation saying one thing to me: people think McClatchy is going bankrupt. I’m here to highlight some points of interest that have me questioning that idea.

Firstly, the operations of the business have their respective highlights. Further, most debt isn’t due until 2022/2029. There are solid ways to handle this debt, and real assets that could help pay it down if sold. Next, accounting for pensions is unique, and McClatchy’s valuation dislocation leaves it in a unique position to benefit from high-finance tailwinds here. And lastly, price action, management changes, and a volume surge tell me the timing is right. Put all of this together and going long may not be as crazy as it seems at first glance.

Revenue Breakdown and Trend Analysis

McClatchy has two main sources of its $977 million in 2016 revenue: “Audience” or circulation & subscription payments, and Advertising, which is in the form of ads online, in classifieds, and through direct marketing campaigns. Subscriptions are to well-known, regionalized publications such as the Miami Herald, The Kansas City Star, and others that end up totaling to 30 total media companies in 29 U.S. markets, with no single publication generating more than 12% of total revenue for the company. While subscription revenue is 37% of McClatchy’s total and advertising is 58%, these numbers are flipped at the New York Times (NYSE:NYT) (with fewer/a singular publication). You can see this in the pie charts and tables below.

EBITDA margins are surprisingly similar between the Times and McClatchy, despite the need for McClatchy to run 30 different publications across the entire country and the Times managing only one. Historically – and I mean dating back to 1987 – McClatchy’s adjusted EBITDA margin has always been substantially higher than the Times’, and it has just recently converged between the two companies around 16%. The margin compression at McClatchy is evident in the $237 million decrease in revenue from 2013 through 2016, forcing management to cut out $116 million in operational costs (per the recent conference call), which leaves us with a net loss of $121 million in pre-tax income that accounts for almost all of the margin compression you see. As noted in the recent conference call, management expects further revenue declines and cost reductions to occur.

What is notable is that the New York Times’ revenue has been much more stable (after adjusting for divestitures) than McClatchy’s. The Times’ revenue is basically flat from 2011 through to today, while McClatchy has lost over $300 million. When you dive in further, it’s evident that the Times was able to offset a small decline in advertising revenues by increasing subscription revenue, while McClatchy’s “Audience” revenue category has seen growth from ~$350 million to $400 million, and advertising revenue has lost a substantial $350 million (~30% contraction). Breaking down subscription numbers solely from the 10-K’s is difficult due to poor and confusing disclosures at the Times, but the general idea I can take away is that circulations have declined, more so at McClatchy. This may be because of the more regional nature of McClatchy’s assets, and leaves McClatchy opportunity to expand its “McClatchy DC” bureau news site while pursuing the digital opportunity. It is clear that the future of major publications is to be on the global stage, and I am confident that is what McClatchy management wants to pursue.

A discussion on revenue trends would not be complete without discussing subscriber and circulation trends at both companies. Unfortunately, the Times does a horrible job of disclosing its subscriber numbers (and I do not have access to AAM reports to analyze as of late). To clarify: the 10-K displays various metrics that do not equate to one another and give little clarity in overall trends for consistent data points. For example, the weekday circulation for the Times was calculated at 1.67 million in 2012, 1.926 million in 2013, and 648,900 in 2014. This 1.3 million circulation change year over year was alarming and unusual, so I took a look at the fine print. When you read the description of the data point, it’s noted that circulation trends included non-print in 2012 and 2013, but were only print in 2014, 2015, and 2016. This kind of trickery is not evident in McClatchy’s numbers that, while comparable to both digital and print circulation for The Times by order of magnitude, are actually consistently reported and noted as print only.

What I can say is that McClatchy discloses its print circulation consistently, and that its 30 publications have a 2.15 million Sunday and 1.5 million weekday circulation. This is 2x and 3x the Times’ weekday and Sunday print-only circulation volumes, respectively. Despite the deceleration of print circulation being greater at McClatchy, it really does beg the question: Is the Times really worth the $1.8 billion enterprise value that is twice as much as the 30 publications McClatchy manages (with an enterprise value of $900 million)? The Times’ value has more than doubled over the past 5 years, while McClatchy has lost nearly 80% of its value. I think it’s time for investors to start paying attention to McClatchy.

A Brief Overview of the Publishing Space

Just so the investor has a background, I want to note the recent trends in publishing. Of the limited macroeconomic data I have access to, you can see United States publishing revenue has collapsed from roughly $25 billion in 2010 to ~$12.5 billion in 2016. The Times generates roughly $1.5 billion, while McClatchy generates close to $1 billion. This negative trend is expected to continue, leading to a $6 billion industry by 2021.

Sifting Through the Financials and Debt

The aggregate numbers of McClatchy’s debt sound scary, but aren’t nearly as threatening as they seem at first glance. This is because while the total principal amount outstanding is $873 million, a lot of it isn’t due until 2022. A cumulative debt schedule is below, as is a cumulative estimate of free cash flow. This model is simply here to get an idea of what inputs we are working with, and is not meant to be my projections, and because of this, it simply leaves CapEx, CFO, and other asset sale options flat or minimal based upon what has been announced. The covenants in the debt allow asset sales to be done, but the proceeds must first be offered to the 2022 bond holders at par before any other holders. This allows for debt reduction across the spectrum of outstanding loans. (The 10-K noted that there was a sale leaseback of a Sacramento property for $67.8 million, with pre-tax payments of $6.2 million for 15 years. I have estimated the cash inflow and an after-tax cash flow impact in following years.)

You’ll notice that things get tight for the company in 2022, when $491 million of first-lien, secured debt comes due. If cash flow is flat throughout the next few years, then there will be a small shortfall that year. I believe there are a few options that investors should consider when evaluating the financial risk apparent:

Tegna (NYSE:TGNA) announced the intent to sell CareerBuilder.com in mid-2016. McClatchy owns 15% of CareerBuilder. Monster.com recently sold itself for $429 million in 2016 with a rough estimate of $600 million in revenue, according to the linked article I cited. Applying the 0.715x P/S multiple to CareerBuilder’s estimated ~$500 million in revenue ($565 million in 2010, per Wikipedia) gets us to a $357.5 million valuation. McClatchy would receive $53.625 million with such a sale.

o CareerBuilder generated $6 million in cash for McClatchy last year (per the 10-K).

In the 10-K, it’s noted that $67.8 million was generated through a sale leaseback of the Sacramento headquarters in January 2017 (included in my model). The company also generated $47.1 million in assets in the form of 6 properties that were contributed to the pension plan in early 2016. The conference call specifically mentions a new Letter of Intent to sell a building in downtown Raleigh (presumably the two-story building located at 111 West Hargett Street in North Carolina), which should fetch a multi-million dollar cash inflow imminently. I also believe it’s possible that of the $300 million+ in net PP&E on the balance sheet, there are further locations fully owned by the company that could be up for leaseback discussions in the future in order to make up the shortfall.

Today, McClatchy has a revolver with over $60 million available to draw down on, at LIBOR+350. While renegotiation of the revolver will be in 2019, it’s likely that something will be available to cover other debt principals in 2022.

Finally, as a last resort and just an interesting observation: McClatchy’s Working Capital/Current Ratio stands at 0.9x today. Today, the New York Times’ is at 2.0x, but it had run as low as 0.6x in 2008. Newspaper operators have been able to run at a negative working current ratio in the past, presumably due to the consistent cash payments from the subscription business. I wouldn’t recommend it for a long period of time, but you can see that with no more debt due until 2027 for McClatchy, the cumulative free cash flow quickly outpaces the total amount owed after the 2022 payment is needed. Such a ratio for McClatchy today would generate over $50 million in cash. (Current assets sit at $167.5-190 million in current liabilities.)

Experienced investors will also understand that just because there will be a principal payment shortfall in one year does not mean the holders of the debt will force a Chapter 7 or Chapter 11 to liquidate. There is a lot that can happen between now and 2022, so I would not start shorting McClatchy expecting a bankruptcy in the future. The short percentage is somewhat elevated at close to 10% of the float, but that doesn’t make the stock as bad an offender as, say, Myriad Genetics (NASDAQ:MYGN) at 38.4%, or Fossil Group (NASDAQ:FOSL) at 27.3%. I believe it shows that investors see a potential life for equity beyond bankruptcy.

One other aspect to note from the table given is that when holding the enterprise value constant and calculating in the paydown of the debt, you have equity whose value grows substantially. There is substantial upside here.

Pension

As mentioned previously, the company has an underfunded pension that is currently frozen (as in, no more benefit liabilities are being accrued). The total calculated underfunding is $605 million as of the last annual filing, and does not require any anticipated cash contributions as of late. Classically minded investors will keep this liability in mind when performing a sum-of-the-parts analysis here. Pensions are actuarial estimates of future liabilities, and theoretically, should be treated as an outstanding debt to be paid. To refresh yourselves on pension accounting, I want to point readers to the surprisingly informative and accurate Investopedia.

As a summary: The funded status of a pension is whether assets of the plan are greater than calculated liabilities, and is calculated as Plan Assets (the current capital held within the company) minus the Projected Benefit Obligation, or PBO. Plan Assets are simple to calculate, because you take the assets held in the pension accounts. The Projected Benefit Obligation is a little more tricky and involves estimation. You take the expected expenses within the pension by assuming a number of actuarial variables, such as the projected life of beneficiaries and their expected payouts, and then discounting the acquired future value to get a present value. While the work is generally done by an actuarial team, the discount rate is a major input that we have visibility into. This visibility comes from regulation dictating that the discount rate for a pension’s present value of future liabilities is to be determined by a 2-year trailing average of “high-grade corporate bonds.”

Today, the discount value stands at 4.52%, which is near the all-time low for the input (see chart). This is interesting because interest rates for the markets have been very low, only to rally near year end, as the Federal Reserve has been increasing interest rates in the market. If the trend continues and the market is able to wean itself off of historically low interest rates, then the discount rate should increase and the PBO should decrease.

These dynamics are true with every pension, but McClatchy is unique because of the level of materiality. According to the company’s 10-K, a 100 basis point increase in the discount rate (1% in high-grade corporate yields) would decrease the PBO by $200 million. Take into account that the enterprise value for the business has hovered near 1.5x revenue post 2014 ($940 million enterprise value + $605 million underfunding = $1.545 billion, when including the pension) and figure a constant TEV/Rev, and you have a scenario akin to when the company pays off its debt with cash. It is the theoretical equivalent of paying down a $605 million debt principal by $200 million, but comes in the form of a shifting interest rate. This should yield a $200 million increase in equity for the respective decrease in debt. Because McClatchy’s market capitalization is only $70 million, you suddenly have a material exposure to interest rates through its equity that could play out by almost tripling the value of the equity – with no fundamental improvements to the underlying business required.

Working Capital

Going back to 3Q09 for analyzing the working capital yields little surprises. One positive thing to note is that accounts receivable has been a stable ~50% of quarterly revenue, so there are no delayed billing shenanigans to bolster revenue in the short term, which I am happy with.

What did catch my eye is McClatchy’s Current Ratio, or Current Assets to Current Liabilities. As you can see, the ratio has dipped below 1x this past year. This can be an issue if the company needs liquidity in the short term, but is more concerning for industrial businesses, where forming relationships with business partners where you are negotiating pay cycles can be difficult to build and manage with a precarious short-term situation on the balance sheet. With newspaper publishing, as with restaurants, the cash-heavy nature of the business allows you to get away with running the deficit for short periods of time. This is actually sighted specifically in the most recent 10-Q filed by Ruby Tuesday (NYSE:RT):

“Our Working capital deficiency and current ratio as of February 28, 2017 were $13.0 million and 0.9:1, respectively. As is typical in the restaurant industry, we typically carry current liabilities in excess of current assets because cash (a current asset) generated from operating activities is reinvested in capital expenditures (a long-term asset), debt reduction (a long-term liability), or stock repurchases (thereby reducing equity), and receivable and inventory levels are generally not significant.”

McClatchy can draw down on a ~$60 million revolver if there is an issue here, so I believe this ratio is management’s choosing.

Recent Developments and Price Action

The past week has been an interesting ride for McClatchy shareholders, with a day of a 10%+ rise in the stock on April 10th that was quickly given back by end of week. This price rise was because the company’s DC headquarters and Miami Herald bureau won 2 Pulitzer prizes for last year’s work. One was for investigative and explanatory journalism regarding their breaking of the Panama Papers, while another was for their political cartoons. What’s important to note here is how this stock played versus NYT (which didn’t budge despite its wins). I believe this points to the fact that good news is generally priced out of McClatchy stock, as the market’s reaction was one where it wasn’t expecting a news bureau around since the mid-1800s to have a shot at a Pulitzer prize. This speaks to the lasting value of great journalism, and shows that McClatchy, though smaller than the New York Times, isn’t irrelevant.

Some other interesting developments for McClatchy include the new CEO who was instated last quarter. Craig Forman is replacing Pat Talamantes, who served as CEO from 2012 onward. Craig has been on McClatchy’s board since 2013, is a former journalist, has been an executive at EarthLink, Yahoo, Dow Jones, and Time Warner, and had led initiatives with Yahoo News, Sports, and Finance in the mid-2000s. He has been a mainstay of the company’s digital initiatives. A CEO switch is almost always a welcomed move for an underperforming company, so I support the decision.

Investors were understandably worried about the timing of this change because it came during the company’s most recent quiet period, which led to speculation that things would be worse than initially perceived. You can see this in real time when you look at the short interest, which spiked in mid-September. Fortunately, that didn’t seem to be the case, as the stock price has stabilized since the earnings call.

What’s even more interesting is the level of buying in early April. The volume surge from 10,000 to 15,000 shares traded daily since September to >50,000/day through the beginning of April means something interesting is happening, and that someone larger than us retail traders decided to make a move.

Historical Valuations – Comparison Isn’t the Idea Here, No Outlier

Looking back it’s interesting to see that the three newspaper publishers traded around 12x TEV/EBITDA and 2.5x TEV/Rev until 2006 and 2007, when they fell to 6x TEV/EBITDA and 1x TEV/Rev, and have yet to rise nearer to their historical averages in the aftermath of the financial crisis. This is obviously due to the encroachment of the internet on physical circulations, and I don’t believe that given current revenue trends, a reversion to the mean is appropriate. This play with McClatchy is not based on a mis-valuation when looking at comparable companies, but within the company itself. If the Enterprise Value stays within its current 1x TEV/Rev range, then even with a 5% annual decline in revenues, it should still be true that as the company generates cash flow and pays off debt, the equity value should rise as it takes up a larger portion of the overall enterprise value.

A 5% decrease in revenue would equate to a little under $49 million in reduced revenue for the year, and at the current 12.5% Accounts Receivable to Annual Revenue run rate, we are looking at a ~$40 million reduced pre-tax cash income, or $26 million in after-tax reduction – still leaving us with around $40 million to go towards debt paydown. This doesn’t include how management guided to further cost reductions in overhead to compensate for revenue losses, but goes to show that the business is not going to start burning cash unless more serious issues arise.

I believe noting a Price/Sales metric in the discussion, as many who are used to more stable balance sheets like to do, is flawed because the debt is so material for the industry.

I do want to just mention that CFO – CapEx has been remarkably similar for Lee, the Times, and McClatchy, who have generated $74 million, $64 million, and $62 million in free cash flow respectively over the past twelve months. Their Enterprise Values are $700 million, $1.8 billion, and $914 million respectively. Think about that huge dislocation.

Conclusion

Investing in McClatchy is a balancing act for investors. On one hand, revenues are deteriorating and the company is forced to shift its business model, while managing a larger burden of debt than its competitors. Fortunately, a sales force revamp has redirected McClatchy to focus on digital advertising beginning this year, and it is focused on being a lean and mean newspaper publisher, while leveraging its strong publication brands to bolster its online presence. The work from the company is of good quality, proven by the recent Pulitzer prizes, and the market seems to respond to such news in fleeting bursts that signal low expectations. Further, the company has a great non-financial asset that it should be able to further monetize as it develops its online presence: its subscriber base that is at least double the Times’.

With a huge free cash flow yield that management is directing towards paying down its debt, which it can do because of the asset-light nature of the industry, and with the tailwinds of interest rates in the near term benefiting the pension situation, I have little doubt that McClatchy will be trading higher in a year’s time as investors hash out the debt on the balance sheet and realize the company has assets it is actively selling to pay it off successfully. McClatchy has simply been a victim of the overarching secular trends in the space, and has not gotten credit for its internal restructuring to date.

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Disclosure:I/we have no positions in any stocks mentioned, but may initiate a long position in MNI over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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